Real estate syndication investing is a leading method of protecting and growing your income and personal wealth today. There are also some valuable tax benefits when you invest in property through a syndication. With the uncertainty of each year’s possible tax increases relative to your assets, income and and net worth, participating in syndication investing can be extremely helpful at tax time.
As a passive investor, or limited partner, in a real restate syndication investing deal, you help fund the property investment. You and the other limited partners contribute funds toward the amount needed to purchase a large property. The general partner(s), or sponsor(s) manages all aspects of the deal.
The sponsor purchases the property, which is typically a large multi-unit property. This apartment building or condominium complex may need renovating, and the ultimate objective is to sell it for a profit. The sponsor manages all of this activity for all of the investors.
The financial return for both the passive investors and the sponsor can be impressive. Yet even more attractive are the significant tax benefits and incentives that these real estate investing (REI) syndication deals offer.
The IRS tax code is actually a group of incentives created to inform tax payers how best to use and invest their income and savings. There are currently massive incentives for investing in passive real estate.
Major Tax Benefits of Passive Real Estate Investing With a Syndicate
The most important tax benefits of investing in real estate as a passive investor with a syndicate include the following:
The allowed tax deduction for property depreciation can be quite large, yet it often goes overlooked by taxpayers. Over time, any investment property in your portfolio will begin to deteriorate. The tax benefit allowed is that you as the passive investor can write off your income-generating real estate according to its degrees of wear and tear.
Understanding Tax Deductions for Property Depreciation
Valuable tax deductions for depreciation of your REI syndication property investments are calculated in the following way:
- Property Value. First, the value of the physical property building or complex must be determined, excluding the value of the land. Next, divide the resulting number by the property’s useful lifespan. The IRS calculates this figure to equal 27.5 years for a residential property investment and 39 years for commercial property like a storage building or warehouse. Every year, you as the property investor can deduct this amount.
As an example, if your apartment building or condo complex building(s), has a value of $700,000, divide this figure by 27.5. The resulting figure of $25,455 is the amount that you can deduct each year on your income tax return for 27.5 years. This enables you to report less profit for each year and reduce your amount of taxes owed to the IRS.
Generally, if you report a loss on your tax report that resulted from property depreciation, you can use it only for the purpose of offsetting passive gains made on other properties or investment types. Yet if you report a modified adjusted gross income that equals less than $100,000, you are permitted to offset $25,000 of your income.
If, however, you report a large amount of loss, you must carry it over to the next year. Some of your active income can be offset, as will be explained in another section below.
- Bonus Depreciation. Tax cuts plus the JOBS Act in 2017 brought changes to some regulations concerning property depreciation. These changes enabled businesses to take depreciation deductions sooner in the lifespan of an investment property. They also raised the amount that can be deducted.
Due to bonus depreciation, you can deduct approximately 25 percent of the building’s purchase price during the first year. As an example, if a large multifamily condo or apartment building is purchased in an REI syndication investment deal for $8 million, the passive investors can deduct $2 million during the first year.
- Depreciation Recapture. At the time your syndication investment property is sold, you will be required to account for the deductions that you have previously taken. Yet the rate is still limited to 25 percent, which is considerably better than the top income tax bracket allowance. In addition, you have successfully deferred tax payments of a number of years.
Capital gains, or the profits that you receive from selling an asset, are taxable income. Yet the tax rate for capital gains is different from the rate for more traditional income. If you hold real estate investment income for longer than one year, it is considered long-term capital gains. The tax rate on this amount caps at 20 percent, which is quite different from the 35 to 37 percent that is most likely due to the IRS on you day job salary.
When you compound these gains over time, you can enjoy significant tax benefits. Examining this information reveals that all income is not taxed equally. Income made from real estate investing through syndication is significantly more beneficial at tax time than your annual income from a day job.
When you refinance, you can borrow funds against the appreciation and gained equity on a syndication investment property free of taxation. As an example, if you purchased an apartment complex for $500,000 and refurbished the property, you can now charge higher rents.
Perhaps the market has also improved, and this property is now valued at $1 million. If you decide on a cash-out refinance, you can take $500,000 of this amount to buy another building. This transaction is totally tax-free. You can make use of this cash to build and strengthen your passive income streams, free of owing any additional taxes.
Mortgage Interest Payments Deduction
As you most likely know, most of the early repayments on a loan go toward paying the interest on the loan. These payments can be used as tax deductions. As with a typical home mortgage, interest payments on a rental property can also be tax deductions. This can be a great financial benefit to you as a passive investor at tax time, particularly during the initial few years of investing in a property.
Losses Carried Forward
Your deductions on property transactions and investment holdings may add up to a net loss on your tax reports. Usually, these deductions and losses are only useful in offsetting other passive income. In this case, all of the distributions that you are issued are tax-free. If your losses surpass your financial gains, you can carry those losses over to offset additional passive income.
Another attractive possibility is to carry these losses into the category of “active” income. This can reduce your overall tax rate significantly. To the IRS, passive income like the income from rental property and active income like the salary from your day job are very different.
In general, losses incurred from passive income are only usable for offsetting other passive income. In order to offset any losses from active income, you most show active losses.
However, with Real Estate Professional Status (REPS), your total passive real estate income and losses can be viewed as active. Once you obtain REPS, you can make use of your real estate losses to reduce your income taxes.
Real Estate Professional Status
Once you acquire Real Estate Professional Status, you can tick the box to identify yourself as such on your tax returns. This will allow your passive REI activities to be viewed as active by the IRS. You can then make use of your real estate losses to reduce your income tax for the year.
Just to be clear, Real Estate Professional Status is not the equivalent of being a licensed real estate agent or broker. You do not need a license or special training to obtain REPS. To qualify for REPS, the IRS requires you to meet the following two criteria:
- Over half of the services that you personally performed in all trades or industries throughout the tax year were in real property trades or businesses in which you had material personal activity.
- You were involved in over 750 hours of services during the tax year in property trades or enterprises in which you had material participation.
Yet gaining REPS is not the best move for everyone who invests passively as a limited partner through a real estate syndication. For expert information, advice and guidance, consult your tax professional.
There are multiple valuable tax benefits associated with real estate syndication investing. When you are a passive investor as a limited partner in a large multifamily property investment deal through a respected REI syndication, you can learn to gain tax advantages from both your gains and your losses.
By understanding the IRS requirements for reporting your investment property depreciation, capital gains, refinancing, mortgage interest deductions and losses carried forward, you can benefit from significant reductions in your yearly income tax payments. If you and your tax professional determine that gaining Real Estate Professional Status (REPS) is right for you, you may receive even greater reductions in your income taxes.